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LESSONS WE CAN LEARN Address by Lawrence K. Roos President Federal Reserve Bank of St. Louis Before the St. Louis Council on World Affairs Stouffer's Riverfront Towers St. Louis, Missouri October 7, 1981 As we have a l l become p a i n f u l l y aware, i n f l a t i o n i s now the most serious problem facing most nations throughout the world. For those i n d i v i d u a l s who have f a i l e d to c o r r e c t l y a n t i c i p a t e the course of i n f l a t i o n , the r e s u l t has been capricious—and often disheartening—weal t h losses. Even f o r those who have attempted to a n t i c i p a t e i t s coming, i n f l a t i o n has produced s i g n i f i c a n t changes i n economic behavior: savings and investment have declined s u b s t a n t i a l l y , p r o d u c t i v i t y has f a l l e n , and f i n a n c i a l markets have experienced increased i n s t a b i l i t y and uncertainty. The general r e s u l t has been lower standards of l i v i n g f o r the c i t i z e n s of t h i s Nation and f o r much of the r e s t of the w o r l d . Today I would l i k e to discuss c e r t a i n aspects of the worldwide r i s e i n i n f l a t i o n t h a t has occurred over the past decade and a h a l f . In p a r t i c u l a r , I would l i k e to share some personal observations and impressions t h a t I gleaned during a recent v i s i t to the United Kingdom, Switzerland and West Germany. social and p o l i t i c a l These observations concern the d i f f e r e n t forces a f f e c t i n g the conduct of monetary p o l i c y in d i f f e r e n t nations. There are three basic propositions t h a t I wish to stress in my discussion: First: t h a t p e r s i s t e n t i n f l a t i o n whenever i t occurs i s a monetary phenomenon; i t results simply from excessive growth of the money supply, - 2 - Second: that central banks are the creators of money and, consequently, in spite of monetary control techniques that differ between nations, they are capable of reducing, even eliminating, inflation if they so choose, Third: that when central banks have chosen not to contain the growth of money and inflation, this choice has usually resulted from pressures exerted by social and political forces that do not especially desire price stability. The first two propositions are most easily demonstrated by simply comparing the monetary expansions and inflation experiences of West Germany, Switzerland, the United Kingdom and the United States over the past fifteen years. As mature, developed and open economies, each of these nations has been similarly affected by a host of non-monetary factors, such as the vagaries of weather, OPEC, and the general expansion of government activities. Yet, in spite of the commonality of these influences on their respective economies, there are discernibly uncommon differences between the four nations in the manner in which they have conducted monetary policy and in the associated inflation they have experienced. During the early 1960s, Switzerland had the highest rate of money growth (over 9 percent per year) and, consequently, the highest rate of inflation (about 5 percent per year). At that time, the United - 3 - S t a t e s , i n c o n t r a s t , had the lowest rate of money growth (about 3 percent per year} and, again, not s u r p r i s i n g l y , the lowest i n f l a t i o n rate (less than 2 percent per y e a r ) . Rates of money growth and i n f l a t i o n i n the United Kingdom and West Germany f e l l somewhere between the United States and Switzerland. What a difference the past f i f t e e n years have made 1 Since the mid-1960s, money growth i n the United Kingdom and the United States has s t e a d i l y accelerated. Over the past f i v e y e a r s , U.S. monetary expansion was more than double what i t was during the early 1960s. Money growth i n the United Kingdom more than t r i p l e d i t s pre-1965 growth r a t e . The patterns of Swiss and West German money growth over the past f i f t e e n years stand i n sharp c o n t r a s t to those of the United States and the United Kingdom. The Swiss rate o f monetary increase has declined sharply since the mid-1960s. West German money growth has shown a mixed pattern—sometimes sharply d e c e l e r a t i n g , sometimes sharply a c c e l e r a t i n g . However, over the past f i v e years i t was less than i t s rate of growth in the e a r l y 1960s. As a r e s u l t of these divergent p a t t e r n s , while i n f l a t i o n has averaged more than 13 percent per year i n the United Kingdom and over 7 percent per year i n the U.S. f o r the past f i v e y e a r s , Germany has experienced only a 4 percent average annual i n f l a t i o n and i n f l a t i o n in Switzerland averaged a miniscule 2 percent per year. Of course, over short p e r i o d s , non-monetary f a c t o r s can also a f f e c t the rate of i n f l a t i o n . For example, as a r e s u l t of OPEC, rates of i n f l a t i o n increased dramatically i n a l l four nations from 1973 to 1975. A f t e r 1975, however, the fundamental r e l a t i o n s h i p between changes i n the - 4 - growth of money and changes in the rate of inflation was reasserted. Inflation declined in West Germany and Switzerland and increased in the United Kingdom and the United States reflecting the different patterns of monetary expansion in these countries. This brief description of the interaction of money growth and inflation demonstrates one point quite clearly. Because West Germany and Switzerland have maintained fairly tight control over the direction of growth of their money.stocks, they have achieved relatively low average rates of inflation. This, unfortunately, was not the case in the United Kingdom and the United States. The important question to be answered is "why the differences?" I believe that the answer can be found in social and political pressures that arise in response to temporary economic "discomforts" which affect certain segments of the econonjy in times of monetary restraint. These discomforts, though painful, are a necessary part of the process essential to winding down inflation. They arise in the following ways. Monetary restraint designed to reduce inflation usually produces some initial, but temporary; adverse impacts on employment and production. Higher unemployment and slow economic growth, however temporary, inevitably generate sentiment to abandon policies of restraint. For monetary restraint to prevail, policymakers must be prepared to permit interest rates to fluctuate freely in accordance with market influences. Unanticipated fluctuations in interest rates have adverse effects on interest rate sensitive sectors of society such as the housing and financial industries. They may also produce movements in foreign - 5 - exchange rates which can have a disturbing effect on export and import industries.. These groups can be expected to react to their discomfort by exerting political pressure upon monetary policymakers to retreat from restraint. Finally, stable monetary control subjects the government to increased financial discipline. It forces government to finance i t s expenditures through higher taxes or through borrowing directly from the public. scrutiny. Either way, the expenditures become subject to greater public And such scrutiny and consequent discipline may not be politically acceptable to those in government. These social and political forces, arising as consequences of monetary r e s t r a i n t , place enormous pressure on monetary policymakers to abandon attempts to control and reduce inflation. If, through the political process, temporary economic protection of certain sectors of society takes precedence over price s t a b i l i t y , the central bank, irrespective of its independence, will find i t increasingly difficult to maintain s t r i c t monetary control. How these social and political pressures influence the conduct of monetary policy is dramatically illustrated in the cases of the United Kingdom, Switzerland and Germany. The United Kingdom, since World War I, has faced changes in worldwide economic and political conditions that have rendered some of i t s economic sectors inefficient. Instead of permitting these industries to decline and new ones to arise in their place—a process that would have entailed a temporary decline in living standards during the transition—the political decision was made to protect the affected - 6 - industries. Government expenditures and government deficits grew; their costs burgeoned. Ultimately, when all else failed, the government i t s e l f entered directly into the business of producing goods and services via nationalization of specific industries. Concurrently, a constituency avolved whose primary goal was to maintain high rates of employment at all_ times and to maintain the existing standard of living despite declining demand and productivity. Over time this constituency grew in political strength and was able to force monetary policymakers to accelerate money growth. This expansion in money growth, and the subsequent higher inflation, did not result from faulty techniques or perverse intentions on the part of the Bank of England. It occurred simply because the central bank responded to ever-increasing pressures from the public and private sectors that benefited from inflationary environment. In Switzerland, the central bank faces significantly kinds of political and social pressures. different For decades, Switzerland has been willing to tolerate the decline of i t s major industries—agriculture and watchmaking—as changes occurred in world economic conditions. For example, at the s t a r t of the 1970s, Swiss watchmakers produced about 80 percent of all watches made. Currently, they produce only about 30 percent and this share is continuing to decline, as watchmaking has shifted to the Orient. The Swiss, in turn, permitted resources to be reallocated into manufacturing and financial service industries, and were willing to endure higher unemployment in the process. Why do the Swiss place greater emphasis on price stability than on employment stability? First, much of the Swiss labor force consists - 7 - of s o - c a l l e d "guest-workers" who are c i t i z e n s o f neighboring nations. Since temporary r i s e s in unemployment f a l l more heavily on "guestworkers", the p o l i t i c a l lessened. impact o f unemployment on the Swiss electorate i s Furthermore, one of the most important Swiss i n d u s t r i e s — t h e p r o v i d i n g of f i n a n c i a l services to the *rest of the world—owes i t s very existence to the s t a b i l i t y of the value of the Swiss f r a n c . Because Swiss manufacturing r e l i e s almost solely on imported raw m a t e r i a l s , and t o some e x t e n t , imported l a b o r , short-term f l u c t u a t i o n s i n exchange rates have l i t t l e net e f f e c t on Switzerland's important export i n d u s t r i e s . F i n a l l y , the Swiss government sector i s r e l a t i v e l y small and i s engaged i n v i r t u a l l y no income maintenance endeavors. Under these circumstances, i t i s easy to see t h a t , although there are a few sectors o f the Swiss economy t h a t would b e n e f i t from p r o t e c t i o n from the s i d e - e f f e c t s of monetary r e s t r a i n t , the Swiss p r o - i n f l a t i o n constituency i s r e l a t i v e l y small. As a r e s u l t , the c e n t r a l bank i s free to control monetary growth i r r e s p e c t i v e of short-term f l u c t u a t i o n s i n i n t e r e s t r a t e s , exchange rates or unemployment r a t e s . West Germany l i e s somewhere between the United Kingdom and Switzerland i n terms of f a c t o r s impacting i t s conduct of monetary policy. Although, l i k e Switzerland, i t i s a society t h a t is dominated by the p r i v a t e sector, i t resembles the United Kingdom i n t h a t i t has numerous income maintenance programs and a large government sector. A l s o , l i k e the United Kingdom, Germany has i n d u s t r i e s t h a t are highly dependent on exports and, t h e r e f o r e , b e n e f i t s from a lower f o r e i g n exchange value of i t s currency. There are also short-run pressures to maintain low i n t e r e s t rates to favor various industries. interest-sensitive - 8 - On the other hand, there are important factors in Germany which contribute to the v i a b i l i t y of a n t i - i n f l a t i o n a r y policies. The Bundesbank is legally independent of the federal government; the prevalence of "guest-workers" mitigates somewhat the concern over higher unemployment, and Germany has not yet been faced with* the problem of declining industries. Most important of a l l , German citizens remember, either f i r s t or second hand, the ravages of the hyperinflation of the early 1920s. They are s t i l l w i l l i n g to suffer some temporary economic dislocations to avoid a repetition of the tragedy of hyperinflation. Thus, while there are growing demands in West Germany for income redistribution and, therefore, for income maintenance p o l i c i e s , the overwhelming p r i o r i t y is s t i l l to prevent an acceleration in i n f l a t i o n . As a r e s u l t , the Bundesbank is free to pursue monetary r e s t r a i n t and to disregard most of the transitional problems that may occur as a result. What lessons can we in the United States learn from these comparisons? Can they be applied to our conduct of monetary policy? F i r s t , the Swiss and West German experiences make i t clear that monetary policy can be used to control and reduce the rate of i n f l a t i o n . The Swiss and West German experiences provide good examples of t h i s . More importantly, however, experience demonstrates that monetary control is possible only i f the central bank has a clear mandate to control i n f l a t i o n . A p o l i t i c a l and social consensus that price s t a b i l i t y is the primary p r i o r i t y and responsibility of the central bank must prevail. Third, i t is obvious that the larger the governmental sector becomes relative to the private sector, the greater are the p r o - i n f l a t i o n - 9 - pressures on monetary policy-makers. consciously desire inflation. This is not because governments Rather, i t is because inflation, especially if i t is unanticipated, makes i t easier for the government sector to expand i t s control over national resources and provide politically desirable services. The United Kingdom and the United States are good examples of this phenomenon. Perhaps the biggest problem that monetary policymakers face today in the United States is that the constituency for sectorial protection, the pro-inflation constituency, is growing. More and more groups, through their elected representatives, have been demanding protection from adverse market pressures and interest rate fluctuations. We protect the unemployed, the elderly and the minorities. We protect farmers, the housing industry, the automobile industry, the t h r i f t industry and the bond dealers. The l i s t can and, unless we do something about i t , will go on and on. Achievement of price level stability implies that all sectors of the econony must be subject to market forces. It is the fear of these market forces that produces powerful political pressures for protection against inflation rather than elimination of inflation. Once this protection syndrome becomes embedded in society, the return to price s t a b i l i t y becomes increasingly difficult. We in the United States are presently at the crossroads. As our inflation-protected constituencies continue to grow, as they encompass an even greater portion of our society, there will be increased pressures on the monetary authorities to abandon their attempts to combat inflation. The events of the past several weeks—the cries of anguish that interest - 10 - rates must be forced down immediately and at any cost—are a reflection of such p o l i t i c a l pressures in action. In a democratic society, even the t i t u l a r l y "independent" central bank cannot remain immune from p o l i t i c a l pressures. As Arthur Burns has noted, the anguish of central*banking arises not from i t s i n a b i l i t y to control money growth, but rather from the d i f f i c u l t i e s that central bankers have in overcoming the p o l i t i c a l pressures associated with monetary r e s t r a i n t . I f we pull back now from our current policy of monetary r e s t r a i n t , we w i l l , once again, have acted to prolong and, perhaps to i n s t i t u t i o n a l i z e i n f l a t i o n in this nation. We must now choose between long-term benefits for all or short-term gains for a few. decision be? What w i l l our
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